"Double Taxation"

• As with all aspects of the Internal Revenue Code, the laws of taxing dividends are written by Congress and subject to change. Prior to 2003, dividends were taxed as normal income at the taxpayer's regular rate. Because the regular income tax is a progressive tax, it assesses high income individuals at a higher rate (as high as 35 percent). When George W. Bush became president, he brought with him the argument that taxing dividends amounted to double taxation since the corporation paid taxes on its earnings and then used that post-tax money to pay its dividends. Soon after, Congress passed the Jobs and Growth Tax Relief Reconciliation Act, which established a new category of so-called "qualified dividends" that would be taxed at a lower rate. For most tax payers, the rate was dropped to 15 percent, while low-income dividend earners would only have to pay 5 percent. The law was originally written to expire December 31, 2008, but was later extended through 2010.
  
  

Qualifying Dividends

• Requirements for qualifying dividends have two basic components. The first relates to the type of dividend or stock they represent, and how it is owned. Dividends earned through mutual funds would qualify (except payments of interest or short-term capital gains), but those paid through an employee stock plan or awarded by a tax exempt charity would not. Dividends on preferred stock do not qualify if the stock is reported as a fixed income investment. For most investors, however, regular dividends on most common or preferred stock satisfies the first condition of qualification. The second component of qualifying dividends is related to when the stocks paying the dividends are purchased, and how long they're held.
  
  

Holding Requirements

• To qualify for the lower tax rate on the dividends, the underlying stock is subject to holding requirements. Common stock must be owned for more than 60 days (not necessarily consecutively) during the 120-day period beginning 60 days before the ex-dividend date. For preferred stock, the requirement is 90 days of ownership during the 180-day period beginning 90 days before the stock's ex-dividend date. The ex-dividend date is the first day of trading after the last day that an investor can buy a stock and have the transaction clear in time to receive the dividend. The bottom line on the holding requirement is that a stock must be purchased at least one day prior to the ex-dividend date, and then held for 60 (or 90) days. If the stock is purchased more than one day prior to the ex-dividend date, then there is some leeway for nonconsecutive days of ownership resulting from active trading.